Chapter 11

Life Insurance
Agenda

• Premature Death
• Financial Impact of Premature Death on
Different Types of Families
• Amount of Life Insurance to Own
• Types of Life Insurance
• Variations of Whole Life Insurance
• Other Types of Life Insurance

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Premature Death

• Premature death can be defined as the

death of a family head with outstanding
unfulfilled financial obligation
– Can cause serious financial problems for the
surviving family members
– The deceased’s future earnings are lost forever
– Additional expenses are incurred, e.g., funeral
expenses and estate settlement costs
– Some families will experience a reduction in
their standard of living
– Noneconomic costs are incurred, e.g., grief

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Premature Death

• Life expectancy has increased significantly

over the past century
– Thus, the economic problem of premature death
has declined
– Millions of Americans still die annually from
heart disease, cancer and stroke
• The purchase of life insurance is financially
justified if the insured has earned income
and others are dependent on those earnings
for financial support

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Financial Impact of Premature
Death on Different Types of Families

• The need for life insurance varies across

family types:
– Single people
– Single-parent families
– Two-income earners with children
– Traditional families
– Blended families
– Sandwiched families

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Amount of Life Insurance to Own

• Three approaches can be used to estimate

the amount of life insurance to own
• The human life value approach
– The amount needed depends on the insured’s
human life value, which is the present value of
the family’s share of the deceased breadwinner’s
future earnings

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Amount of Life Insurance to Own

• To calculate the amount needed under the

human life value approach:
– Estimate the individual’s average annual
earnings over his or her productive lifetime
– Deduct taxes, insurance premiums and self-
maintenance costs
– Using a reasonable discount rate, determine the
present value of the family’s share of earnings
for the number of years until retirement

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Amount of Life Insurance to Own

• Under the needs approach, the amount

needed depends on the financial needs that
must be met if the family head should die
• The calculation should consider:
– An estate clearance fund
– Income needed for a 1-2 year readjustment period
– Income needed for the dependency period, until
the youngest child reaches age 18
– Life income to the surviving spouse, including
income during and after the blackout period.
– Special needs, e.g., funds for college education
and emergencies
– Retirement needs

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Amount of Life Insurance to Own

• The capital retention approach preserves

the capital needed to provide income to the
family
• To calculate:
– Prepare a personal balance sheet
– Determine the amount of income-producing
capital
– Determine the amount of additional capital
needed to meet the family needs

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Amount of Life Insurance to Own

• Many families have only a limited amount of

discretionary income
– The purchase of life insurance reduces the
amount of discretionary income available for
other needs
– Many families are in debt and have little savings
– After payment of high priority expenses, such as
a mortgage, food and utilities, many families
have only a limited amount of income to
purchase life insurance

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Types of Life Insurance

• Life insurance policies can be classified in

two general categories:
– Term insurance provide temporary protection
– Cash-value life insurance has a savings
component and builds cash values
– There are many variations of both types
available today

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Types of Term Life Insurance

• Under a term insurance policy, protection is

temporary; protection expires at the end of
the policy period, unless renewed
• Most term policies are renewable for
additional periods
– Premiums increase at each renewal
– To minimize adverse selection, many insurers
have an age limitation beyond which renewal is
not allowed

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Types of Term Life Insurance

• Most term policies are convertible, which

means the policy can be exchanged for a
cash-value policy without evidence of
insurability
– Under the attained-age method, the premium
charged for the new policy is based on the
insured’s attained age at the time of conversion
– Under the original-age method, the premium
charged for the new policy is based on the
insured's original age when the term insurance
was first purchased
– A financial adjustment is also required

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Types of Term Life Insurance

• Yearly-renewable term insurance is issued

for a one-year period
• Term insurance can also be issued for 5 or
more years
• A term to age 65 policy provides protection
to age 65, at which time the policy expires
• Under a decreasing term insurance policy,
the face value gradually declines each year

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Types of Term Life Insurance

• Under a reentry term insurance policy,

renewal premiums are based on select
(lower) mortality rates if the insured can
periodically demonstrate acceptable
evidence of insurability (i.e., good health)
• Return of premiums term insurance is a
product that returns the premiums at the
end of the term period provided the
insurance is still in force.

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Uses and Limitations of Term Life
Insurance
• Term insurance is appropriate when:
– The amount of income that can be spent on life
insurance is limited
– The need for protection is temporary
– The insured wants to guarantee future
insurability
• However,
– Term insurance premiums increase with age at
an increasing rate and eventually reach
prohibitive levels
– Term insurance is inappropriate if you wish to
save money for a specific need

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Exhibit 11.2 Examples of Term Life
Insurance Premiums

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Types of Whole Life Insurance

• Whole life insurance is a cash-value policy

that provides lifetime protection
– A stated amount is paid to a designated
beneficiary when the insured dies, regardless of
when the death occurs
– Types include:

• Ordinary life • Universal life

• Limited-payment life • Variable universal life
• Endowment insurance • Current assumption whole life
• Variable life • Indeterminate-premium whole life

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Types of Whole Life Insurance

• Ordinary life insurance is a level-premium

policy that provides lifetime protection
– Premiums are level throughout the premium-
paying period
– The excess premiums paid during the early years
are used to supplement the inadequate premiums
paid during the later years of the policy.
– The insurer’s legal reserve is a liability that must
be offset by sufficient financial assets
– The net amount at risk is the difference between
the legal reserve and the face amount of coverage

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Exhibit 11.3 Relationship Between the Net Amount
at Risk and Legal Reserve (2001 CSO Mortality Table)

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Types of Whole Life Insurance

• Another characteristic of ordinary life

insurance policies is the accumulation of
cash surrender values
– A policyholder overpays for insurance protection
during the early years, resulting in a legal
reserve and the accumulation of cash values
– The policyowner has the right to borrow the cash
value or exercise a cash surrender options
• An ordinary life policy is appropriate when
lifetime protection is needed
– A major limitation is that some people are still
underinsured after the policy is purchased

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Types of Whole Life Insurance

• Under a limited-payment life insurance

policy, the insured has lifetime protection,
and premiums are level, but they are paid
only for a certain period
– The most common limited-payment policies are
for 10, 20, 25, or 30 years
• A paid-up policy at age 65 or 70 is another
form of limited-payment life insurance
• A single-premium whole life policy provides
lifetime protection with a single premium

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Types of Whole Life Insurance

• Endowment insurance pays the face amount

of insurance if the insured dies within a
specified period. If the insured is still alive
at the end of the period, the face amount is
paid to the policyholder
• Endowment insurance accounts for less than
one percent of the life insurance in force

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Variations of Whole Life Insurance

• Universal life insurance is a flexible

premium policy that provides lifetime
protection
– After the first premium, the policyholder decides
the amount and frequency of payments
– Most policies have a target premium, but the
policyowner is not obligated to pay it
– The protection and savings components are
unbundled

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Variations of Whole Life Insurance

• There are two forms of universal life

insurance:
– Option A pays a level death benefit during the
early years, and the death benefit increases in
later years to meet the corridor test required by
the Internal Revenue Code
– Option B provides for an increasing death benefit
which is equal to a constant net amount at risk
plus the accumulated cash value

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 Exhibit 11.4
Two forms of
Universal Life
Insurance
Death Benefits

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Exhibit 11.5
$100,000 Universal
Life Policy, Level
Death Benefit, Male
Age 25, Nonsmoker,
5.5 Percent Assumed
Interest (con’t)

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Exhibit 11.5
$100,000
Universal Life
Policy, Level
Death
Benefit, Male
Age 25,
Nonsmoker,
5.5 Percent
Assumed
Interest

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Variations of Whole Life Insurance

• Universal life provides considerable

flexibility
– Cash withdrawals are permitted
– Policies receive favorable tax treatment
• Limitations include:
– Insurers advertise misleading rates of return
– Cash-value and premium-payment projections
can be misleading and invalid
– Insurers can increase the mortality charge
– A policy may lapse because some policyowners
do not have a firm commitment to pay premiums

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